A Disaster Waiting to Happen

Medicare bureaucrats wreck the medical ­equipment market.

Eli Lehrer

August 15 - August 22, 2011, Vol. 16, No. 45

Sometime late this summer—the Friday before Labor Day if historical patterns hold—the Centers for Medicare and Medicaid Services (CMS) will announce the beginning of something called Medicare Round Two of “the Competitive Bidding Program for certain Durable Medical Equipment, Prosthetics, Orthotics, and Supplies.” Although it sounds obscure, this bidding process’s manifest flaws could have serious consequences for just about every American who needs medical care. Shortages of vital devices could develop, medical supply companies could go out of business, medical innovation could slow, and, if things go as badly as some economists think they will, health care costs could skyrocket as the direct result of a program intended to control them.

The story of the bidding process for what insiders call DMEPOS provides a fascinating case history of how broadly supported “good government” schemes can have serious negative consequences in the hands of ambitious bureaucrats. Let’s begin with some background. Durable medical equipment, prosthetics, orthotics, and supplies, i.e., DMEPOS, are goods used primarily outside of hospitals. The category includes everything from crutches to pacemakers. DMEPOS are mainly distributed through small “home care/durable medical equipment” businesses that earn most of their revenue through “market rate” reimbursements under the Medicare program. The current purchasing process has problems: Among other things, prices for the same equipment differ quite a bit between regions, invoices rarely track manufacturing costs, and quality problems crop up more frequently than they should.

In an effort to save money for Medicare while boosting quality, Medicare began full-scale competitive bidding for some products under the 2003 law adding prescription drug coverage to Medicare. Under that law and an additional package of Medicare tweaks passed in 2008, the bidding process would begin in a few areas and, if successful, expand. (The 2010 health care law accelerates this expansion.) At the time, it seemed like common sense, good-government thinking. Supporters of bidding processes included the George W. Bush administration, then Senate majority leader Bill Frist, and Frist’s late Democratic colleague Ted Kennedy. CMS claims it will obtain average savings of nearly 20 percent, or about $1.5 billion out of the more than $8 billion Medicare spent on DMEPOS in 2009.

Despite a long buildup period, however, nobody paid much attention to the process until CMS announced a plan for a bidding system that raised questions for just about every expert that has looked at it.

“Neither I nor anyone else have ever seen any bidding process anywhere that works this way,” says University of Maryland professor Peter Cramton, an economist who has closely followed the Medicare bidding process. And nearly 250 university and industry economists who study market-design economics have signed Cramton-drafted letters to the president and CMS expressing grave concerns about the process and suggesting that it be halted until its flaws can be worked out. (There’s no groundswell of academic support on the other side.)

The fundamental problem lies in the way that CMS’s market design crashes the established procedures for government contract bidding. In a conventional bidding process for a government contract, qualified providers submit bids offering specific quantities of a product at a particular price. The bidding process ends when the total that the providers offer equals expected demand. This is called the “market clearing price.” If, for example, CMS decides there’s a need for 100 walkers and gets bids of 25 walkers for $90 each, 25 walkers for $110 each, 50 walkers for $140 each, and 100 walkers for $150 each, it would establish a “clearing price” of $140, hold all bidders to their bids, and decline to do business with the company that wanted $150. This process becomes considerably more complex in real-world settings, but its fundamental efficiency in meeting demand at the lowest cost ranks among the best-established conclusions in the field.

While it takes bids in a normal fashion, however, the CMS process insists that Medicare will pay everyone the median of the “winning” prices. ($110 rather than $140 in the above example.) As a result, some bidders will be paid less than they bid while others will be paid more. Unlike in a conventional government bidding process, CMS neither requires bidders to prove they can deliver a product before bidding nor to actually deliver it afterwards. And unlike all other government auctions outside of the national security realm, CMS reveals little besides winners’ names to the public.

All these features could cause major problems. Since bidders don’t have to honor their bids or prove they can meet them in the first place, they have enormous incentives to bid less than their actual costs, because doing so gives them a zero-risk option to sell to CMS at a price that may be higher than the bid anyway. Since CMS pays less than the likely-to-be-low “clearing price,” however, the system essentially guarantees that some will have to sell at a loss or drop out and thereby threaten their own survival. Finally, since nearly everything is kept secret, CMS’s own officials are free to manipulate contracts however they want. The result is a disaster waiting to happen for the market as a whole.

In the trial areas, problems have already emerged. Diabetics have run into difficulty getting supplies that work with their testing meters and CMS has had to rejigger delivery quantities for almost every major item it has put out for bids. While these short-term fixes have prevented calamity, the fragile, nearly arbitrary process that now exists could show real strains as soon as the “round two” process expands current practices to a total of 91 metropolitan areas that collectively contain almost the entire population.

In fact, just about every independent study of the process makes decidedly dour predictions. One report from the Pacific Research Institute finds that CMS’s methods could reduce investment in medical device markets by as much as $3.1 billion over a 10-year period (essentially stopping the development of new high-tech devices) and cost $50 billion in terms of reduced life expectancy. Another report from the American Consumer Institute finds that the process’s consequences for one category of equipment—vacuum pumps that help heal serious wounds—would increase medical costs by $6.8 billion if it slows the technology’s rollout. “The CMS bidding process is so flawed that it will fail to find sustainable market prices for medical equipment,” says Steve Pociask, ACI’s chief economist and the study’s author. But CMS has given every indication it plans to push forward with the process unchanged.

And that’s where the bureaucratic interests come in. Since the process puts low prices above all other considerations, it will almost certainly produce savings of more than the 20 percent that experiments have shown, and its designers will look very smart. With only a few areas and a few classes of products in play, however, firms may have been willing to take losses up until now just to stay in the running. The people running the program at CMS probably hope they will emerge looking like geniuses who saved taxpayers billions, while the home care industry will get the blame as quality falls, shortages develop, deliveries become irregular, innovation ceases, and more people end up in hospitals.

Cramton adds an important note. “It’s rare to see something like this happening in the absence of an organized interest group on the other side,” he told me. “Usually somebody benefits from the flaws in a process. Here, no special interest group benefits.” Unless, of course, one believes the CMS’s own leadership ought to be counted as another special interest group with an agenda all its own.